Investing Like a Young Warren Buffett

| About: Berkshire Hathaway (BRK.A)

By James Caan

The following article contains a blueprint, suggesting formulas and functions to use with a stock screener to find stocks a young Warren Buffett would buy. These stocks are not just cheap, they have low debt levels, high quality management and strong profit margins.

A lot of us wish we could invest like Warren Buffett — and for good reason. Buffett and his partners acquired control of Berkshire Hathaway (NYSE:BRK.A) in 1965. Since then, by taking positions in publicly traded companies such as McDonalds (NYSE:MCD) and buying other companies outright, Buffett transformed Berkshire into, in effect, a closed-end mutual fund.

To say that shareholders who got in at the beginning have benefited mightily is an understatement. According to Forbes, Berkshire (Class A) shares were worth $15 apiece when Buffett took over the floundering textile manufacturer. The last time I looked, they were changing hands at $87,000 a share.

You can get in on the action by buying Berkshire Hathaway stock. Although Class A shares will set you back the aforementioned $87,000, Class B shares (NYSE:BRK.B) can be had for only $2,900 and change. What's the difference? Not much. Besides representing less ownership, the only disadvantage of Class B shares is that you have limited voting rights compared to Class A shares.

Beyond Berkshire

But buying Berkshire shares may not be the best way to profit from Buffett's stock-picking wisdom. Here's why.

Buffett is your classic buy-and-hold investor and rarely sells. Consequently, Berkshire's portfolio is stuffed with stocks bought years ago. For instance, Buffett added Coca-Cola (NYSE:KO) in 1988, and it's still Berkshire's biggest holding. American Express (NYSE:AXP), the portfolio's second-largest holding, was added in the 1960s.

It's possible that Berkshire's portfolio is laden with tired stocks whose best days are behind them. A close look at the performance numbers lends credence to that argument.

As of July 2004, Berkshire Hathaway shareholders had enjoyed a 16.1% average annual return over the previous 10 years, easily beating the S&P 500's 9% or so annual return over the same period. But that 16% figure was no match for the blistering 31.7% average annual return that Berkshire racked up in the prior 10 years (July 1984 to July 1994). So while recent Berkshire Hathaway returns are still impressive, they are not keeping up with the earlier pace.

Also, Berkshire's wholly owned company portfolio is heavily weighted with insurance stocks, making its performance susceptible to a downturn in that industry.

All things considered, picking stocks that a young Buffett would buy if he were just starting out today may be a better alternative than buying into Berkshires existing holdings. Here are some ideas about how you might go about doing that.

Get inside Buffett's head
Buffett hasn't yet written a book describing how he picks stocks, but he gives tantalizing hints in his Chairman's Letter that accompanies each Berkshire annual report. You can download the letters going back to 1977 from the Berkshire Hathaway site.

For best results, plan on spending some time getting familiar with Buffett's thinking through his letters or by reading a book on the topic. Countless authors have penned books purporting to describe Buffett's stock-picking strategies. Those by mutual fund manager Robert Hagstrom and by Buffett's ex-daughter-in-law, Mary Buffett, generally get the best reviews. Hagstrom’s most recent title is The Essential Buffett: Timeless Principles for the New Economy. From Mary Buffett, look for “The New Buffettology.”

Although Buffett trained under legendary value guru Benjamin Graham, he pays as much attention to a company's products, profitability, growth prospects and management quality as he does to valuation.

In a nutshell, Buffett strives to identify highly profitable companies capable of generating strong future earnings growth. To that end, he looks for companies with a sustainable competitive advantage, which, for him, usually translates to a strong brand name. Stocks such as McDonalds, Gillette (NYSE:G) and H&R Block (NYSE:HRB), all major Berkshire holdings, are examples.

Buffett doesn't look at analysts' forecasts to predict future growth. Instead, he relies on the companys historical results. This requires an in-depth understanding of its business plan. He seeks out companies with strong management and demonstrated expertise in their industry. Conversely, he avoids companies that expand outside their area of expertise.

Ill explain in more detail as I describe a screen for finding stocks that a young Warren Buffett might find interesting.

The Young Buffett screen
Although he doesn't rule out companies currently experiencing rough times, Buffett insists on a strong profitability history. He relies on return on equity (ROE) to gauge profitability, but he also uses return on invested capital (ROC) to rule out high-debt stocks.

Return on equity is a company's net income divided by shareholders' equity (book value). If you do the math, youll find that a company can't internally fund earnings growth faster than its ROE. For instance, a company with a 10% ROE can't grow earnings faster than 10% annually without raising additional cash by selling more shares or borrowing. Those are both no-nos for Buffett, who prefers low-debt companies that, if anything, are buying back shares.

Most money managers I've talked to look for a minimum 15% ROE. Since Buffett is pickier than most, I upped that requirement to 17%. Try reducing it if you don't get enough candidates.

Screening Parameter: ROE: 5-year Avg. >= 17%

Watch return on capital
Because debt reduces shareholders’ equity, all else being equal, a high-debt company would have a higher ROE than one with low or no debt. Return on invested capital (ROC) takes debt out of the equation by adding it back to shareholder equity before doing the calculation. If a company carries no long-term debt, its return on capital would be the same as its return on equity. However, for a high-debt company, ROC would be much lower than ROE.

I required a minimum 17% ROC to rule out high-debt companies. If you reduce your ROE requirement, you'll also have to cut ROC by the same amount.

Screening Parameter: Return on Invested Capital: 5-year Avg. >= 17%

Profit margins
Buffett looks for companies with above-average profit margins. If you're rusty on your stock-market math, profit margins are not the same as ROE, which is a profitability ratio. Net profit margin is total net income (bottom line income after all deductions) divided by total sales for the same period. For instance, a company would have a 10% net profit margin if it earned $10 million on sales of $100 million ($10 million divided by $100 million).

In theory, the company with the highest net profit margin is the most profitable. However, for a variety of reasons, different companies in the same industry may be paying different income-tax rates, distorting the profitability comparison.

Using pretax margins in place of net profit margins eliminates that problem by using net income before deducting income taxes.

I emulated Buffett's penchant for picking the most profitable companies in an industry by requiring that a passing stock's five-year average pre-tax profit margin must be at least 20% higher than industry average.

Screening Parameter: Pre-tax profit Margin: 5-year Avg. >= 1.2* Industry Avg. Pretax Margin: 5-year Avg.

Buffett values stocks using a gauge he dubbed "owner earnings", which is reported earnings with noncash expenses such as depreciation and amortization added back in and capital expenses subtracted. Buffett's " owner earnings" is similar to the more familiar term free cash flow.

Buffett doesn't want to overpay, and the price-to-cash flow ratio approximates his approach to valuing stocks. I emulated how I think he thinks by specifying a maximum ratio no more than 80% of the industry average.

Screening Parameter: Price/cash flow ratio <= 0.8* Industry Average price/cash flow ratio

I also required a positive ratio to rule out negative-cash-flow stocks.

Screening Parameter: Price/cash flow ratio >=0.1

Buffett frowns on high-debt companies, but his definition of high and low varies with each industry. I use the debt-to-equity ratio (long-term debt divided by shareholders equity) to measure debt, and I require a passing stocks D/E to be no higher than 80% of the industry average.

Screening Parameter: Debt to Equity Ratio <= 0.8*Industry Average Debt to Equity Ratio

Management quality
Buffett emphasizes the importance of picking companies with great management, which can be a subjective exercise. But income per employee, which is a company's net income divided by its employee count, is an objective gauge of management's effectiveness. Generally, the higher the income per employee, the better the management. I'm guessing that Buffett would likely consider a company that exceeds its industry average in that department by at least 10% to be well managed.

Screening Parameter: Income per employee >= 1.1* Industry Average Income per employee